There was no other choice – now George Osborne must hold his nerve

 
Allister Heath
IT was a timely reminder that action is desperately required to tackle Britain’s out of control budget deficit. At 9:30 yesterday morning, a full three hours before George Osborne got up to deliver his spending review to the House of Commons, the latest monthly budget deficit figures popped up on traders’ screens across the City. They were absolutely grim. Public sector net borrowing rose again to £16.2bn in September, a record deficit for the month. Even though the economy had grown during the past 12 months, that figure was even higher than the £15.5bn suffered a year ago.

The fine print was just as depressing. True, VAT receipts were up 17.2 per cent year-on-year in September, not surprisingly given that the rate was taken back up to 17.5 per cent during that time. However, the year-on-year increase in income and capital gains tax receipts slowed to a disappointing 1.5 per cent.

In part, this is because pay growth is now so weak – for the first time, Osborne may be regretting his war on City bonuses. In part, this low revenue growth is because hiking direct tax is not bringing in as much as the Treasury was hoping for. The 1,000 or so hedge fund mangers who have quit the UK have left behind a £500m-£1bn black hole in the numbers; hiking capital gains tax may also have backfired.

Just as ominously, the breakdown of central government expenditure shows interest payments shot up to £2.3bn in September, from £912m a year earlier - an increase of 155 per cent.

So Osborne’s determination not to shy away from the challenge of implementing a dramatic reduction in the state’s share of the UK economy is to be welcomed – and was indeed broadly given the thumbs up by the City. The coalition’s credibility as a responsible government with a firm grip on the public finances was reinforced yesterday; however, some of the details turned out to be a bit murky, especially the emergence of vicious £1bn green stealth tax on business involving carbon credits, which rightly angered many. At times, the review – and especially Osborne’s speech – reminded one of Gordon Brown’s statistical sleights of hand, though at least now all of the published documents have been audited by Robert Chote’s independent Office for Budget Responsibility.

It turns out that total spending will fall, in real terms, by 3.3 per cent by 2014-15, less than the 3.6 per cent promised at the emergency budget. The difference is that an extra £2bn will be spent on capital projects (and thus an extra £2bn borrowed); this slight loosening of fiscal policy won’t derail Osborne’s target, which is to eliminate the structural deficit on current spending. What has changed much more dramatically is the composition of the cuts, which now involve reducing welfare by a further £7bn, on top of the £11bn announced in June, in return for cutting departmental spending by substantially less.

While cash spending goes up every year, it will do so at a slower rate than inflation, which means that total expenditure will fall in real terms. By way of a benchmark, since 1970, total real spending has only fallen in five years. One of Osborne’s long-term challenge will therefore be to actually deliver on his real term cuts against the massive opposition of the public sector, unions and large swathes of the public. It is a historic mission.

In real terms, the total cuts are worth £23.3bn a year by 2014-15. But while that is the number economists and financial markets care about – and is clearly too low to derail the economy, let alone push it into a double-dip, as some critics claim – this is not the figure that matters when it comes to gauging the impact on the public. The surge in interest payments will continue to gobble up a much larger share of the overall public sector spending cake, meaning that the squeeze to government departments and welfare is much larger than the headline figures suggest.

The real cut to government departments will hit £42.2bn a year by 2014-15, or roughly 10 per cent; while much less than previously feared, this will hurt a lot of people. Many of the reforms to the welfare system – an additional cut of around £18bn a year in real terms by 2014-15 – will also have a substantial impact, on the middle classes as well as on the poor. But it is a shame that the debate is being confused by the coalition’s obsession with the idea that it has saved much more than that; its figure of £81bn doesn’t really exist or at least doesn’t describe “cuts” as ordinary mortals would understand them. It is derived from a baseline which assumes continuous growth in welfare payments; it also includes a £10bn “cut” from lower interest payments caused by the coalition’s prudence. It is strange that the coalition seems intent on deliberately exaggerating the scale of its own cuts.

Public spending will drop from 47.7 per cent of GDP in 2009-10 and 47.3 per cent in 2010-11 (on the Treasury’s figures) to 41.0 per cent of GDP in 2014-15. As Investec points out, Osborne’s planned reduction in the budget deficit is of a similar order of magnitude to the 8.3 percentage point improvement seen during John Major’s fiscal consolidation of the early 1990s (a deficit of 7.7 per cent in 1993-94 became a surplus of 0.5 per cent in 1998-99). However, this occurred at a time when the economy was growing by 3.5 per cent per annum, compared with the OBR’s forecast of an average 2.5 per cent growth looking ahead. This shows the magnitude of the task facing Osborne; it is always easier to cut a deficit when the economy is booming.

The Institute for Fiscal Studies calculates that the revised plans imply the deepest six-year period of cuts to public services spending (defined as all expenditure minus debt and welfare payments) since the six years starting in April 1976. A few months ago, it seemed that these cuts would have been significantly deeper – the sharpest, in fact, since the Second World War, a comparison which Labour wrongly continued to use yesterday. This is an important shift, psychologically as well as in terms of what the majority of the public will experience. Within governments, the cuts are very uneven: to offer some protection to spending on schools, hospitals and defence, the axe is to fall hard on higher education teaching, social housing, environment, food and rural affairs, local government and justice. Weirdly, foreign aid will reach record levels. The plans also assume no increase in the EU budget until 2013/14, then a massive rise of 24 per cent (£2bn) in nominal terms to 2014/15. Bizarre.

The pain across the public sector will be severe, with a net 490,000 state sector jobs being abolished over the next four years, albeit mostly through vacancies not being filled rather than redundancies. Some believe that an additional 500,000 private sector jobs could also be lost among contractors and others. But the other side of the coin is that OBR believes that private sector jobs will rise by a net 1.5m during the same time.

All in all, this was a courageous spending review from Osborne, who was right to mostly stick to his tough approach. There were the odd lapses, especially the £1bn tax hike on business and the absence of any new pro-growth policies other than the preservation of spending on Crossrail.

But it is clear that the coalition is serious about dragging Britain out of our fiscal morass. Its next challenge will be to hold its nerve as opposition and protests begin to mount.

allister.heath@cityam.com